China's economic growth has begun to inch down from its record rates earlier in 2007, while food prices are lifting inflation, notes the World Bank's China Quarterly Update released today.

The slowdown in the 4th quarter was due to a lower contribution of net exports, as external demand slowed, partly offset by stronger domestic demand. Food prices lifted headline inflation to 6.5 percent in December, but there is to date no apparent significant overall excess demand or spill-over of high food prices into general inflation.

The Quarterly Update finds that the global outlook has weakened and is uncertain, but concludes that China is likely to grow robustly in 2008 and is well-positioned to stimulate demand if needed. "The slowdown in the global economy should affect China's exports and investment in the tradable sector," says David Dollar, Country Director for China. "However, the momentum of domestic demand should remain robust and a modest global slowdown could contribute to rebalancing of the economy." The World Bank now projects a solid 9.6 percent GDP growth for 2008. If the global slowdown will be more pronounced, China is in a strong macroeconomic position to stimulate demand by easing fiscal policy and/or credit controls. Inflation concerns make lowering interest rates or relaxing liquidity management less obvious. Uncertainties in the outlook call for vigilance and flexibility.

Macroeconomic policy needs to address the challenges of inflation and persistent external surpluses, notes the Quarterly. Overall price pressures should ease in 2008 as some factors behind high food prices taper off. But there are risks, including from international food prices and wage cost pressures, and inflation is not likely to decline to low levels soon. "The inflation concerns call for relatively tight monetary policy," says Louis Kuijs, Senior Economist and main author of the Quarterly". However, interest rates are constrained by the authorities' concern of attracting interest-sensitive capital inflows. Thus, with the external surplus expected to remain very large, monetary policy will continue to rely on credit controls and liquidity management. Continuing to appreciate the RMB against the US dollar will help dampen inflation pressures and reduce the current account surplus.

The government recently introduced further administrative measures to contain inflation. Their objective is to dampen price rises, keep items affordable, and manage expectations. In the long run, the detrimental incentive effects that they generate are likely to outweigh the benefits. The government has rightly announced its intention not to rely on them for long. Given China's strong fiscal position, the authorities could consider replacing some price controls with direct subsidies, ideally targeted at needy groups.

The recent revision of purchasing power parity (PPP) estimates does not change the conclusions about China's growth and poverty reduction. A special focus article notes that the new estimates revise up considerably China's price level, relative to other countries, and thus revise down the size of China's economy in PPP terms. The revised PPP estimates do not change our understanding of real growth. "With the new relative price data, the World Bank's estimate of the US$1 per day (PPP) poverty rates will go up modestly," says Dollar. "However, estimates for earlier years will be revised upwards as well. The revision does not change the fact that China has had the largest and fastest poverty reduction in history." Another special article discusses China's railway transport issues.

(China Development Gateway February 4, 2008)